Chapter 13 The Foreign Exchange Market

Copyright © 2009 Pearson Prentice Hall. All rights reserved Chapter Preview In this chapter, we develop a modern view of exchange rate determination that explains recent behavior in the foreign exchange market. Topics include: – Foreign Exchange Market – Exchange Rates in the Long Run – Exchange Rates in the Short Run – Explaining Changes in Exchange Rates

Copyright © 2009 Pearson Prentice Hall. All rights reserved What are Foreign Exchange Rates? Two kinds of exchange rate transactions make up the foreign exchange market: – Spot transactions involve the near-immediate exchange of bank deposits, completed at the spot rate. – Forward transactions involve exchanges at some future date, completed at the forward rate.

Copyright © 2009 Pearson Prentice Hall. All rights reserved Why Are Exchange Rates Important? When the currency of your country appreciates relative to another country, your country's goods prices  abroad and foreign goods prices  in your country. 1.Makes domestic exporters less competitive 2.Makes domestic importers more competitive 3.Benefits domestic consumers (you)

Copyright © 2009 Pearson Prentice Hall. All rights reserved How is Foreign Exchange Traded? FX traded in over-the-counter market 1.Most trades involve buying and selling bank deposits denominated in different currencies. 2.Trades in the foreign exchange market involve transactions in excess of $1 million. 3.Typical consumers buy foreign currencies from retail dealers, such as American Express. FX volume exceeds $3 trillion per day.

Copyright © 2009 Pearson Prentice Hall. All rights reserved Exchange Rates in the Long Run Exchange rates are determined in markets by the interaction of supply and demand. An important concept that drives the forces of supply and demand is the Law of One Price.

Copyright © 2009 Pearson Prentice Hall. All rights reserved Exchange Rates in the Long Run: Law of One Price The Law of One Price states that the price of an identical good will be the same throughout the world, regardless of which country produces it. Example: American steel costs $100 per ton, while Japanese steel costs 10,000 yen per ton.

Copyright © 2009 Pearson Prentice Hall. All rights reserved Exchange Rates in the Long Run: Law of One Price Law of one price  E = 100 yen/$

Copyright © 2009 Pearson Prentice Hall. All rights reserved Exchange Rates in the Long Run: Theory of Purchasing Power Parity (PPP) The theory of PPP states that exchange rates between two currencies will adjust to reflect changes in price levels. PPP  Domestic price level  10%, domestic currency  10% – Application of law of one price to price levels – Works in long run, not short run

Copyright © 2009 Pearson Prentice Hall. All rights reserved Exchange Rates in the Long Run: Theory of Purchasing Power Parity (PPP) Problems with PPP 1.All goods are not identical in both countries (i.e., Toyota versus Chevy) 2.Many goods and services are not traded (e.g., haircuts, land, etc.) 3.Transportation costs and tarrifs

Copyright © 2009 Pearson Prentice Hall. All rights reserved Exchange Rates in the Long Run: PPP

Copyright © 2009 Pearson Prentice Hall. All rights reserved Exchange Rates in the Long Run: Factors Affecting Exchange Rates in Long Run Basic Principle: If a factor increases demand for domestic goods relative to foreign goods, the exchange rate  The four major factors are relative price levels, tariffs and quotas, preferences for domestic v. foreign goods, and productivity.

Copyright © 2009 Pearson Prentice Hall. All rights reserved Exchange Rates in the Long Run: Factors Affecting Exchange Rates in Long Run Relative price levels: a rise in relative price levels cause a country’s currency to depreciate. Tariffs and quotas: increasing trade barriers causes a country’s currency to appreciate.

Copyright © 2009 Pearson Prentice Hall. All rights reserved Exchange Rates in the Long Run: Factors Affecting Exchange Rates in Long Run Preferences for domestic v. foreign goods: increased demand for a country’s good causes its currency to appreciate; increased demand for imports causes the domestic currency to depreciate. Productivity: if a country is more productive relative to another, its currency appreciates.

Copyright © 2009 Pearson Prentice Hall. All rights reserved Exchange Rates in the Long Run: Factors Affecting Exchange Rates in Long Run The following table summarizes these relationships. By convention, we are quoting, for example, the exchange rate, E, as units of foreign currency / 1 US dollar.

Copyright © 2009 Pearson Prentice Hall. All rights reserved Exchange Rates in the Long Run: Factors Affecting Exchange Rates in Long Run

Copyright © 2009 Pearson Prentice Hall. All rights reserved Exchange Rates in the Short Run In the short run, it is key to recognize that an exchange rate is nothing more than the price of domestic bank deposits in terms of foreign bank deposits. Because of this, we will rely on the tools developed in Chapter 4 for the determinants of asset demand.

Copyright © 2009 Pearson Prentice Hall. All rights reserved Exchange Rates in the Short Run: Expected Returns on Domestic and Foreign Assets We will illustrate this with a simple example François the Foreigner can deposit excess euros locally, or he can convert them to U.S. dollars and deposit them in a U.S. bank. The difference in expected returns depends on two things: local interest rates and expected future exchange rates.

Copyright © 2009 Pearson Prentice Hall. All rights reserved Exchange Rates in the Short Run: Expected Returns on Domestic and Foreign Assets Al the American has a similar problem. He can deposit excess dollars locally, or he can convert them to euros and deposit them in a foreign bank. The difference in expected returns depends on two things: local interest rates and expected future exchange rates.

Copyright © 2009 Pearson Prentice Hall. All rights reserved Exchange Rates in the Short Run: Expected Returns and Interest Parity

Copyright © 2009 Pearson Prentice Hall. All rights reserved Exchange Rates in the Short Run: Expected Returns on Domestic and Foreign Assets What this shows is simple. As the relative expected return on dollar assets increases (decreases), both François and Al respond by holding more (fewer) dollar assets and fewer (more) foreign assets. This leads us to our formal title for what is going on here: Interest Parity

Copyright © 2009 Pearson Prentice Hall. All rights reserved Example: if i D = 6% (US interest rate) and i F = 3% (foreign currency interest rate), what is the expected appreciation of the foreign currency? Exchange Rates in the Short Run: Expected Returns and Interest Parity Interest Parity Condition – $ and F deposits perfect substitutes (2)

Copyright © 2009 Pearson Prentice Hall. All rights reserved Several things to recognize about the interest rate parity condition: Expected returns are the same in both dollars and foreign assets Equilibrium condition for the foreign exchange market Next, we will develop supply/demand curves to explain how the exchange rate is determined. Exchange Rates in the Short Run: Expected Returns and Interest Parity

Copyright © 2009 Pearson Prentice Hall. All rights reserved Exchange Rates in the Short Run: Expected Returns and Interest Parity To determine the equilibrium condition, we must first determine the expected return in terms of dollars on foreign deposits, RF. Next, we must determine the expected return in terms of dollars on dollar deposits, RD.

Copyright © 2009 Pearson Prentice Hall. All rights reserved Deriving the Demand Curve The demand curve connects these points and is downward sloping because when E t is higher, expected appreciation of the dollar is higher.

The demand curve is related to:

Copyright © 2009 Pearson Prentice Hall. All rights reserved Deriving the Supply Curve – There isn’t really anything to derive. We will take the quantity of bank deposits, bonds, and equities as fixed with respect to exchange rates.

Copyright © 2009 Pearson Prentice Hall. All rights reserved Exchange Rates in the Short Run: Equilibrium Equilibrium – Supply = Demand at E* – If E t > E*, Demand < Supply, buy $, E t  – If E t Supply, sell $, E t  The following figure illustrates this.

Copyright © 2009 Pearson Prentice Hall. All rights reserved Exchange Rates in the Short Run: Equilibrium

Copyright © 2009 Pearson Prentice Hall. All rights reserved Explaining Changes in Exchange Rates To understand how exchange rates shift in time, we need to understand the factors that shift expected returns for domestic and foreign deposits. We will examine these separately, as well as changes in the money supply and exchange rate overshooting.

Copyright © 2009 Pearson Prentice Hall. All rights reserved Explaining Changes in Exchange Rates: Increase in i D 1.Demand curve shifts right when – i D  : because people want to hold more dollars 2.This causes domestic currency to appreciate.

Copyright © 2009 Pearson Prentice Hall. All rights reserved Explaining Changes in Exchange Rates: Increase in i F 1.Demand curve shifts left when – i F  : because people want to hold fewer dollars 2.This causes domestic currency to depreciate.

Copyright © 2009 Pearson Prentice Hall. All rights reserved Explaining Changes in Exchange Rates: Increase in Expected Future FX Rates 1.Demand curve shifts left when –  : because people want to hold more dollars 2.This causes domestic currency to appreciate.

Copyright © 2009 Pearson Prentice Hall. All rights reserved Explaining Changes in Exchanges Rates Similar to determinants of exchange rates in the long-run, the following changes increase the demand for foreign goods (shifting the demand curve to the right), increasing – Expected fall in relative U.S. price levels – Expected increase in relative U.S. trade barriers – Expected lower U.S. import demand – Expected higher foreign demand for U.S. exports – Expected higher relative U.S. productivity These are summarized in the following slides.

Explaining Changes in Exchanges Rates

Explaining Changes in Exchanges Rates (cont.)

Copyright © 2009 Pearson Prentice Hall. All rights reserved Applications Our analysis allows us to take a look at the response of exchange rates to a variety of macro-economic factors. For example, we can use this framework to examine (1) the impact of changes in interest rates, and (2) the impact of money growth.

Copyright © 2009 Pearson Prentice Hall. All rights reserved Application: Interest Rate Changes Changes in domestic interest rates are often cited in the press as affecting exchange rates. We must carefully examine the source of the change to make such a statement. Interest rates change because either (a) the real rate or (b) the expected inflation is changing. The effect of each differs.

Copyright © 2009 Pearson Prentice Hall. All rights reserved Application: Interest Rate Changes When the domestic real interest rate increases, the domestic currency appreciates. We have already seen this situation in Figure 4 (slide 37). When the domestic expected inflation increases, the domestic currency reacts in the opposite direction – it depreciates. This is shown on the next slide.

Copyright © 2009 Pearson Prentice Hall. All rights reserved Explaining Changes in Exchange Rates: Response to i  Because π e 

Copyright © 2009 Pearson Prentice Hall. All rights reserved Application: Interest Rate Changes Changes in domestic money supply are a bit more complicated. We summarize the results on the next slide. However, you may want to read the text on this section to fully digest the effects.

Explaining Changes in Exchange Rates: Changes in the Money Supply 1.M s , P , E e t+1 , shifting demand curve from D 1 to D 2. 2.In long run, i D returns to old level, and demand shifts from D 2 to D 3 (exchange rate overshooting)

Copyright © 2009 Pearson Prentice Hall. All rights reserved Exchange rate volatility Exchange rate overshooting is important because it helps explain why foreign exchange rates are so volatile. Another explanation deals with changes in the expected appreciation of exchange rates. As anything changes our expectations (price levels, productivity, inflation, etc.), exchange rates will change immediately.

Copyright © 2009 Pearson Prentice Hall. All rights reserved Applications Our analysis also allows us to take a look at the weak dollar in the 1980s, and (partially) explain why it became stronger in the 1990s and 2000s. We present a summary in Figure 9, on the next slide.

Daily foreign exchange rate ?e=FOREX The Dollar and Interest Rates 1.Value of $ and real rates rise and fall together, as theory predicts 2.No association between $ and nominal rates: $ falls in late 1970s as nominal rate rises

Copyright © 2009 Pearson Prentice Hall. All rights reserved Case: The Euro’s First Nine Years The euro debuted in 1999 at $1.18 / euro. It declined to $0.83 by October 2000, but has recovered, trading at $1.35 by the end of Initially, the European countries had relatively weaker economies, but that has reversed in recent years, weakening the dollar relative to the euro.

Copyright © 2009 Pearson Prentice Hall. All rights reserved The Practicing Manger: Profiting from FX Forecasts Forecasters look at factors discussed here FX forecasts affect financial institutions managers' decisions If forecast euro appreciate, yen depreciate, – Sell yen assets, buy euro assets – Make more euros loans, less yen loans – FX traders sell yen, buy euros